Liquidity of United States fixed income markets plays a central role in U.S. economic activity, the stability of the financial system and successful implementation of Federal Reserve (Fed) monetary policy.
Given its importance, it is essential for market participants to monitor liquidity changes closely. Over the past five years, BNY Buy-Side Trading Solutions and Mellon Investments have observed significant shifts in liquidity of U.S. fixed income markets. What caused these movements, and how can investors anticipate (and potentially benefit from) them? Having accurate and up-to-date data is essential in this regard.
This whitepaper examines recent liquidity trends and introduces a new proprietary liquidity metric developed by BNY’s Buy-Side Trading Solutions1 team. This unique metric was designed to provide a deeper understanding of liquidity trends based on insights derived from our trading data. These insights help to shape our understanding of the shifts in liquidity and their impact on U.S. fixed-income markets. And they can also be used to better understand rapid changes in the liquidity market.
Liquidity in the U.S. Fixed Income Market has been episodically turbulent since 2020:
- Market liquidity deteriorated in early 2020 as investors grappled with the economic uncertainty caused by the COVID-19 pandemic. During a 12-day period in March 2020, the Fed delivered 150 basis points of rate cuts, bringing the benchmark lending rate to near-zero. The rate cuts, coupled with the reintroduction and launch of several asset purchase programs aimed at restoring liquidity, allowed the Fed to successfully stabilize financial markets in the second half of 2020.
- In the period from 2021-2022, U.S. consumer spending momentum, global supply-chain shortages and the conflict in Ukraine contributed to a sharp surge in inflation. The rise in inflation led the Fed to rapidly increase interest rates, resulting in renewed deterioration of market liquidity.
- Although markets restabilized in early 2023, the U.S. regional banking crisis tested the resilience of liquidity once again with the largest bank failures since the 2008 financial crisis, as Silicon Valley Bank and Signature Bank collapsed.
- The Fed's quantitative tightening actions finally began paying off in late 2023, leading to a decline in inflation and improvement in market liquidity. However, uncertainty on the size of the Fed rate cuts has led to a slight decline in liquidity as 2024 draws to an end.
In the view of BNY's Buy-Side Trading Solutions and Mellon Investments teams, the rapidly changing underlying liquidity environment in the U.S. creates new opportunities in fixed income markets. Through the lens of BNY’s Buy-Side Trading Solutions team, we examine the evolution of fixed income liquidity over the past four years. The team has analyzed the liquidity based on an extensive trading dataset, covering the U.S. Treasury and Mortgage-Backed Security (MBS) markets.
Measuring Fixed Income Liquidity
In collaboration with Mellon, one of the world’s largest index managers,2 Buy-Side Trading Solutions executes a significant volume of fixed income trades daily and has unique insights into fixed income market liquidity thanks to its extensive proprietary database of trade metrics. The dataset used in this paper consists of approximately 500,000 quotes and 80 attributes per quote and covers the period from January 2019 to August 2024. It provides a snapshot of Treasury and MBS trades executed by Buy-Side Trading Solutions over the past five years.
For the purpose of this analysis, we define liquidity as the ease with which securities transactions can be executed without causing a significant impact on price. Specifically, this paper considers four metrics using data from Treasury and MBS trades:
- Best3 Quotes: A measure of brokers bidding/offering at the best price,
- Quote Spread: The difference between the best and worst quote for a given trade,
- Time to Quote: The average time that elapses before dealers provide quotes after a trade request,
- Missing Quotes: The percentage of brokers not providing a quote.
These metrics are weighted to create a Liquidity Score for Treasury and MBS markets. Idiosyncratic variances have been removed by the application of a rolling average over time, which is used to create the final score as a linear combination of the four metrics.4
To create the Liquidity Score, Buy-Side Trading Solutions takes the following steps for each of the four metrics:
- Calculate a daily rolling 30-day average.
- Determine the percentile rank against the full dataset of that metric.
- Create the Liquidity Score as an equal-weighted sum of the percentile ranks, with the score ranging from zero to one.
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